Banks are institutions designed to optimize the transfer of funds from savers to borrowers.

However, with lending comes the inherent risk that loan repayments might fall behind schedule or that the borrower might not be able to repay the debt altogether. Therefore, sound banking hinges profoundly on the quality of the loans in the portfolio of the bank.

After the financial crisis of the late 2000s, non-performing loans (NPLs) have become an increasing matter of concern for banks in many European countries. Financial regulators have tried to bring clarity to this topic by, first of all, harmonizing the definition of NPLs and non-performing exposures (NPEs), to better monitor them and to offer a more comprehensive supervision.

Given the wide array of options currently available to the banks and the forthcoming new reporting standards, a deep knowledge of the topic and a very specialized skillset are required to effectively manage the NPL risk.

Definition of Non-Performing Loan
According to the Basel definition, a loan is considered non-performing when the borrower is 90 days or more behind on the contractual payments or when the obligor “is unlikely to pay its credit obligations to the banking group in full, without recourse by the bank to actions such as realizing the security.” However, given the discretionary nature of the “unlikely to pay” part of the definition, market practice has been quite diverse between jurisdictions.

The Causes of NPLs
Even if banks perform in-depth assessments of the borrowers’ creditworthiness, a certain number of assets will deteriorate over time nonetheless. Two sets of factors are considered the main determinants of NPLs. One set focuses on the macro environment, which affects the capacity of the borrower to repay the loan, while the other set focuses on the idiosyncratic factors of the bank.

In the first category, it is well documented that NPLs show an anti-cyclical behavior, as higher gross domestic product (GDP) growth improves the debt servicing ability of the debtors. Furthermore, exchange rate depreciation negatively affects debts issued in foreign currency. The impact of inflation is more ambiguous, where higher inflation reduces the burden of real debt, but at the same time it reduces the real income of the borrower. Finally, the interest rate fluctuations affect the servicing of the debt for variable rate loans.

In the second category, it has been suggested that the objective of profit maximization actively pursued by the management might involve loosening the requirements for the borrowers, thus worsening the quality of the loans (“moral hazard”). Furthermore, low cost efficiencies are usually correlated with poor management practices that in turn increase the NPL ratio. On the other hand, high cost efficiency might reduce the resources allocated to the monitoring of the loans, therefore increasing NPLs. Finally, managers might not have the skills to assess and manage risks.

The Consequences of NPLs
For the bank, the immediate consequence of an increase in NPLs is higher capital requirements to absorb potential losses, and the ensuing rise in funding, management and administrative costs. The rising costs are usually transferred to the borrowers e.g. households and private sector, slowing credit and GDP growth. In a worst-case scenario, there might be systemic failures leading to bank and borrower insolvencies. This, in turn, leads to price declines and a rise in the real debt burden due to the higher number of forced liquidations. High levels of real debt make borrowers less willing to spend, reducing the income even for the individuals and the firms that were not heavily indebted.

The Role of Loan Loss Provisions and Capital
While loan loss provisions (LLPs) are intended to offer a buffer against expected losses, capital is intended as a buffer against unexpected losses. There is, therefore, an important trade-off between the two.

Provisions reduce the value of the assets on the balance sheet. The consequence of this asset reduction is a lower income during that period and therefore lower equity. In extreme cases, these losses can reduce the bank’s capital to below the minimum requirement and bring insolvency and losses for the shareholders. There is, therefore, a strong incentive for the bank to lower the LLPs. Historically, European banks have under-provisioned compared to their U.S. counterparts.

NPL Management
Banks can follow mainly three avenues to clean their balance sheets, but all have pros and cons:

On-Balance Sheet Approach: The bank protects part of its portfolio through external guarantees (structured solution) or by setting up an internal bad bank. This approach can be implemented quickly but due to the high structural complexity, the interest from outside investors is usually limited

Off-Balance Sheet Approach: Banks and Financial Institutions have been trying to recycle NPL’s using arms length sales at fair value to off balance sheet entities often times funded by the bank, or through securitizations. Toxic assets are removed from the balance sheet entirely, but the operational complexity is usually very high and transactions costs might be significant

Passive Rundown Approach: The bank keeps the problematic assets in the balance sheet and manages them internally

The second option is not always appealing when the bank has under-provisioned, as the sale price might be lower than the net amount (i.e., book value - provisions) the bank keeps in its books. The bank would incur a loss in such a case. Market studies seem to confirm that this is the main reason for many European banks to hold onto their assets, rather than pursuing the outright sale approach.

For the economy as a whole and the regulators, the last option is the least attractive as managing distressed debt should not be part of a bank’s business model. Furthermore, a number of studies show that an active approach, despite being associated with short-term costs, has a positive impact on the GDP growth.

IFRS 9 Implications
IFRS 9 is expected to replace IAS 39 in 2018. So far, under IAS 39, provisions have operated on an incurred loss model, where impairments have to be recognized only after the credit event happens (i.e., they are backward-looking). This promotes pro-cyclical lending and asset price bubbles. On the other hand, the forward-looking interpretation prescribed by IFRS 9 operates on an “expected loss” approach, where provisions have to be made against possible not just probable losses.

As a consequence, in a world where provisions are made on a forward-looking basis, the number of days a loan is past due becomes less relevant, because every loan carries a certain provision amount by definition. Furthermore, the forward-looking approach should lessen to a great extent the issue of under-provisioning and spur more market transactions of single assets or portfolios of NPLs, as in the off-balance sheet approach.

Solutions
The Complex Asset Solutions practice at Duff & Phelps can leverage its extensive expertise of the fixed-income asset class and access to relevant databases of transactions and property appraisals to offer a comprehensive set of services in the NPL space. These services include but are not limited to:

Valuation of NPL portfolios

Independent review of the assets to be included in the sale

Exploration of alternative transaction structures and terms

Decision and timing of the sale

Assistance in preparing confidential information memorandums

Negotiation support and assistance in presentations to potential investors